How to Use a 529 Plan for College

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It’s one thing to know that you want to send your child to college. It’s another thing entirely to actually figure out how to start saving. These days, the average college tuition costs more than $145,000 — which is a daunting number for any family. To cover that sum, most students cobble together a mix of grants, scholarships, and student loans. But there are usually gaps leftover. Sometimes, these gaps are significant.

According to the Education Data Initiative, about half of all education costs are covered by parental income and savings. And a full 37% of parents rely on a specialized college savings account to store and generate those funds. Among these college savings accounts, the government-sponsored 529 plan is among the most popular. But how exactly does a 529 plan work? And how can you use one to pay for college? Here’s what you need to know.

FAQs: How to use a 529 plan for college

Opening and using a 529 savings account can sometimes feel complicated. Here are some of the most frequently asked questions about how to use a 529 plan for college.

What is a 529 savings plan?

A 529 savings plan is a type of investment account designed to help students and their families save money for education. You can open a 529 plan for yourself, or you can designate a family member as the beneficiary. When the designated beneficiary starts school, the account holder can withdraw money from the 529 plan and use it to cover the student’s education expenses.

Unlike some other types of tuition savings accounts, 529 plans are fairly flexible. You can use them to cover primary school tuition, high school tuition, college room and board, continuing education, and a variety of other education expenses. However, the most popular use of a 529 plan is covering college education.

Because a 529 plan is an investment account, the funds grow over time. The longer the money sits, the more it grows. That makes these kinds of accounts ideal for long-term education plans. The other benefit of a 529 plan is the tax benefits. In many states, taxpayers can deduct their contributions from their tax bill, generating even more savings.

How does money in a 529 plan grow?

Though 529 plans are sometimes called “529 savings accounts,” this is a bit of a misnomer. Instead of locking your money away in a bank, your 529 plan keeps it actively invested in stocks and bonds. So, unlike with traditional savings accounts, the money you put in a 529 plan tends to grow relatively quickly.

When you first open your 529 plan account, you get to choose from a few different investment options. This allows you to customize your portfolio, i.e., the mix of stocks and bonds you’d like to invest your money in. Choosing an aggressive portfolio — one that relies heavily on the stock market — can be risky, but it also has the potential to grow your money extremely quickly.

What are the tax benefits of a 529 plan?

Unlike traditional savings accounts, 529 plans are “tax-advantaged.” In other words, they can save you money at tax time in a few different ways.

For one thing, any money you contribute to a 529 plan grows tax-deferred. That means you don’t have to pay taxes on capital gains made while your money is in your 529 plan. And if you use your 529 funds for qualified educational expenses, your withdrawals will be tax-free — in other words, you won’t have to pay taxes on your capital gains at all. Because a 529 plan can shelter investment earnings from income tax, it’s a great way to quickly inflate your college fund.

A 529 plan may also qualify you for tax credits or deductions. While the IRS doesn’t allow you to deduct 529 contributions from your federal income taxes, some states do consider contributions tax-deductible for state purposes. If your state allows tax deductions, that means you can subtract your 529 contributions from your taxable income. This will reduce your state taxes by a small amount. If your state offers tax credits, that’s even better: it means you get to deduct your 529 contributions directly from your state income tax bill. That can save you even more money.

Can I still qualify for financial aid if I have a 529 plan?

One of the potential downsides of a 529 plan is that it can affect your eligibility for federal financial aid. If you have more than about $10,000 in 529 plan funds, the IRS will count the excess as a parental asset. The greater your parental assets, the higher your expected family contribution as determined by the Free Application for Federal Student Aid (FAFSA). So, if you have a ton of money in a 529 plan, you’ll likely qualify for less financial aid.

However, qualifying for less financial aid isn’t necessarily a bad thing if the tradeoff is more savings. That’s because student loans can be a huge burden. If you don’t pay them off quickly, they can cost thousands of dollars in interest charges. So, if you qualify for fewer federal loans because you’re able to pay for more of your school tuition out of pocket, you’ll end up with less student loan debt. That will leave your personal finances healthier in the long run.

How do I withdraw funds from a 529 plan?

The 529 account owner can start making tax-free withdrawals as soon as the designated beneficiary starts going to school. You can withdraw money from a 529 plan in a few different ways:

• Transfer money directly from your 529 plan to the school to cover tuition and fees

• Transfer plan funds into a personal bank account or brokerage account, then use the cash to pay education-related bills

• Withdraw plan funds to reimburse yourself for education expenses you’ve already paid

If you decide to go with one of the latter two methods, just be sure to keep your receipts. If you can’t prove that your distributions were used to cover qualified education expenses for a qualifying educational institution, you could get slammed with hefty penalties.

If the designated beneficiary is living off-campus, also make sure you’re not withdrawing more money for room and board than your school estimates is necessary. Check the cost of attendance figures listed online. If you use plan funds to pay for room and board in excess of what’s listed, you could be penalized.

The other caveat is that withdrawals must be made in the same calendar year as the expenses they’re meant to cover. So, if it’s December and you need to pay for some college costs you incurred earlier in the month, don’t wait until January to initiate a transfer. Because it can take several days to process withdrawals, it’s best to give yourself a generous buffer. Try to contact your plan administrator to initiate a withdrawal at least a week or two before the end of the year. If you miss this window, you’ll end up with a current-year disbursement and a last-year expense. Reporting that at tax time can be messy.

What expenses can I cover with my 529 savings?

The IRS lets you use a 529 college savings plan for any college costs required for enrollment. That includes mandatory supplies like books and electronics, as well as your university tuition bill. Here are some of the most common qualified higher education expenses:

• Textbooks and supplies

• Computers or equipment

• Software or internet access

• Room and board, up to the amount listed on your school’s official cost of attendance

• Student loan repayments

• Tuition expenses

• Institution fees

A 529 savings plan doesn’t just cover college expenses for four-year schools, either. As long as the designated beneficiary is enrolled at least half-time, distributions can be used to cover primary school, secondary school, or any post-secondary institution that qualifies for federal student aid. The U.S. Department of Education maintains a list of eligible educational institutions. This list includes a number of apprenticeship programs, vocational schools, and graduate school programs in addition to four-year colleges.

Note: If you’re not at least a half-time student, or if you use your distributions to cover ineligible expenses, you could get dinged for making a “nonqualified withdrawal.” The penalty is steep — as much as 10% of the amount you withdrew. If you’re not sure if a withdrawal is qualified or not, call your school’s financial aid office or consult with a financial advisor.

Is a 529 plan the same as a prepaid tuition plan?

There are two different types of college savings plans: prepaid tuition plans and education savings plans.

Prepaid tuition plans are usually state-sponsored and can only be used for public, in-state colleges and universities. They let you lock in current tuition rates by prepaying for future semesters of school. Prepaid tuition plans do not cover room and board.

Education savings plans, on the other hand, can be used for almost any level of education, including K-12 tuition. You can use them to cover any eligible expenses — including room and board. Like prepaid tuition plans, education savings are sponsored by state governments. However, they can be used for a much wider range of schools.

What happens if I have leftover funds in my 529 plan?

If you graduate before you can spend all of your 529 plan funds, don’t panic. You won’t lose access to your funds, and there are still a few ways you can use the money. You can:

1. Transfer the money to another beneficiary, such as a child or another family member who’s planning to attend college in the future. (You can transfer 529 funds without tax consequences.)

2. Keep the money in your 529 account in case you decide to pursue an advanced degree later in your career.

3. Use the money for qualifying continuing education programs, including wilderness trips with groups like Outward Bound.

4. Roll over the leftover funds into a Roth IRA.

See how much you could save with Earnest

A 529 plan is one of the best ways to start building savings for college. Thanks to its versatility, robust investment options, and tax-deferred status, it can help you grow your education fund much faster than a traditional savings account. And if you start saving early, you could end up with a significant sum by the time you start college. If you’re late to the game, you can still benefit from a 529 plan, but you may need to consider alternative ways of funding your higher education. This could include scholarships, federal financial aid, or private student loans.

If you’re considering private education loans as part of your college funding plan, consider a flexible, low-cost student loan from Earnest¹. With Earnest, you can choose your interest rate type, repay the loan on your own schedule, and skip a payment² once per year without a penalty. Check your rate today to see how much you could save.

This blog post provides personal finance educational information, and it is not intended to provide legal, financial, or tax advice.

¹ Before applying for private student loans, it’s best to maximize your other sources of financial aid first. It’s recommended to use a 3-step approach to assembling the funds you need: 1) Look for funds you don’t have to pay back, like scholarships, grant and work-study opportunities. 2) Next, fill out a FAFSA(R) form to apply for federal student loans. Federal Direct subsidized and unsubsidized loans, excluding PLUS Loan for Parents and PLUS Loan for Graduate and Professional Students which require a credit check and a credit worthy endorser if the parent or graduate or professional student has adverse credit, do not require a credit check or cosigner, and offer various protections if your struggling with your payments. 3) Finally, consider a private student loan to cover any difference between your total cost of attendance and the amount not covered in steps 1 and 2. For more information, visit the Department of Education website at https://studentaid.ed.gov.

² Earnest clients may skip a payment through a one, one-month forbearance during a 12 month period. Your first request to skip a pay can be made once you’ve made at least 6 months of consecutive on-time full principal and interest payments, and your loan is in good standing. The interest accrued during the skipped month will result in an increase in your remaining minimum payment. The final payoff date on your loan will be extended by the length of the skipped payment periods. Any unpaid accrued interest may capitalize (added to the principal balance) at the end of the forbearance period by adding unpaid accrued interest to the outstanding principal as permitted by law and the terms of the loan agreement.